What is a Prepayment Penalty?

IN THIS GUIDE

While paying off a mortgage loan earlier than expected might be a rewarding experience, a borrower should also be aware they may be facing a possible prepayment penalty. A prepayment penalty, or a prepay penalty, is a fee put in place by the lender when a loan is paid back earlier than expected. This allows the lender to make up for lost interest caused by early repayment.

The amount of the prepayment penalty can vary on several factors, including the state in which the loan is taken out. If a borrower is hoping to pay their loan off early, it is important for them to fully understand the conditions of the prepayment penalty (if applicable).

What is a Prepayment Penalty?

A prepayment penalty is a fee when a mortgage loan is paid off sooner than expected. A company faces a high level of risk when issuing a loan, therefore it charges interest each month to insure against that financial risk. When a loan is paid back quickly, the company loses out on these interest payments. In this case, the company has a prepayment penalty set in place to offset any financial loss.

The law does require that the lender disclose the prepayment penalty upfront. This information can be found in the fine print of the contract (the loan estimate) or in the monthly billing statement if you already have the loan. A borrower can also ask the lender to clearly point out where the prepayment penalty clause is in the contract.

Types of Prepayment Penalties

There are two types of prepayment penalties: hard and soft prepayment penalty.

A hard prepayment penalty applies a fee if the borrower sells or refinances the home. A soft prepayment penalty, on the other hand, only applies when the borrower refinances the home. With a soft prepayment penalty, there is no fee if the owner needs to sell their home for whatever reason.

Of the two, a hard repayment penalty is the most restrictive option.

Prepayment Penalty by State

The Dodd-Frank Act set up limitations on prepayment penalties. Currently, federal regulations state that a prepay penalty is only applicable when a loan is paid in full within 36 months of the closing of the loan. The prepay penalty also cannot exceed more than 2% of the amount prepaid.

While the federal regulations set a standard that all states must follow, different states follow different rules as far as determining the exact amount regarding the prepayment penalty. Some states, Nevada, Massachusetts, and Maine, don’t have any prepayment penalty clauses.

Taking a look at California Real Estate legislation, the law states that lenders can impose a prepayment penalty clause if:

  1. The lender also offers an alternative loan that does not include a prepay penalty.
  2. The lender provides the details of the prepayment penalty and all other buyers’ information at least 3 days before loan consummation.
  3. The prepayment penalty does not exceed the amount prepaid in any 12 months above 20% of the original principal amount.
  4. The lender does not impose the prepayment fee if the covered loan was accelerated as a result of default.
  5. The borrower cannot refinance the prepayment fee through a new loan from the same source.

 

Not all states have the same regulations, so it’s always advisable to read the fine print of the contract or even ask the lender about their prepayment penalty clause.

How Much Does a Prepayment Penalty Cost?

Lenders may have different methods for determining the amount of a prepayment penalty. Here are some common methods used:

  • Percentage of principle. For a mortgage loan on a primary residence, the lender assigns a fixed percentage of the outstanding principal as a penalty fee if full payment is made in the first 24 to 36 months of the loan contract. The prepay penalty for a commercial real estate loan could be significantly longer, sometimes extending up to 10 years.
  • A number of months. The borrower pays a certain number of months’ interest.
  • Fixed amount. The lender sets a fixed amount for paying off a loan earlier, though this is less common in mortgage loans.
  • Sliding scale. This is the most common method of determining penalty costs and depends on mortgage length and mortgage rate. As an example, if the loan is paid off within the first year of the loan term, the prepayment penalty is 2% of the outstanding principal balance. If the loan is paid off in the second year of the loan term, the prepayment penalty is 1% of the outstanding principal balance.

 

The prepay penalty method used for a particular loan will be clearly outlined in the loan documents.

Example of a Prepayment Penalty

Let’s say you took out a 30-year mortgage for $500,000 at 4% which includes a prepayment penalty clause. This clause uses a sliding scale that starts at 2% and goes down by 0.5% each year over the first three years of your loan.

If you refinance your loan (or even sell your house under a hard contract) after one year, you will pay approximately $7,200 as the prepayment penalty. If you refinance your loan after two years, you will pay approximately $4,400 in penalties. If you refinance your loan after two and a half years, you will pay approximately $3,150. Notice how as more time passes, the more desirable the penalty is for the borrower.

Now flash-forward a year from purchase and you find you have better interest rates available. You’ve found a lender that will refinance your remaining loan of $480,000 for 30 years at 3%. If you were to refinance your original loan after one year, the prepayment penalty would be $7,200. Conversely, you would save approximately $350 in monthly payments. In this scenario, it would take nearly 21 months to cover the cost of the prepayment penalty.

What Type of Loans Include a Prepayment Penalty Clause?

As previously mentioned, The Dodd-Frank Act was enacted to protect those looking to become homeowners. Under these tighter regulations, the buyer is further protected from unfair penalties. That being said, there are specific real estate loans to expect to see a prepayment penalty clause in.

Fixed-Rate Mortgage Loan

You can expect to see a prepayment penalty clause in a standard fixed-rate mortgage loan, also known as a conventional loan. Generally, this penalty is three months’ worth of interest payments and an interest rate differential (IRD).

Adjustable-Rate Mortgage (ARMs)

An adjustable-rate mortgage generally includes a prepayment penalty clause, although not exclusively so it is possible to shop around for an option that does not have this clause. Most lenders will set the prepayment penalty at 3% the first year, 2% the second year, and 1% the third year.

Interest-Only Mortgage

Interest-only mortgages also tend to include a prepayment penalty clause in the contract. The rates are similar to that of an adjustable-rate mortgage.

Owner Occupied Loan

This is a loan only available to borrowers who are residents of their own property. An owner-occupied loan may have a prepayment penalty clause.

You can anticipate a prepayment penalty clause in most areas of real estate. You will not, however, find prepayment penalties in government loans. Some examples of government loans are Federal Housing Administration (FA) loans and Veterans Affairs (VA) loans.

When is it Worth the Cost to Pay the Prepayment Penalty?

Similar to the example given earlier, it is beneficial to calculate the savings in monthly payments you make when refinancing a real estate loan and compare it to the prepayment penalty. If the savings exceed the prepayment penalty, it would make financial sense to refinance your loan. Don’t forget to include closing costs in your calculation, as these can be significant in certain situations.

If the cost of the prepayment penalty is a big concern, or the benefits don’t outweigh the prepay penalty, then it might be more beneficial to wait out the clause. Since prepayment penalty clauses on primary residences don’t exceed three years, the borrower is free to refinance or sell without any penalty after that time. For commercial real estate loans, a longer prepay penalty clause of up to 10 years will have to be taken into consideration.

Conclusion

While not all contracts include prepayment penalties, it is important for a borrower to be aware of the circumstances surrounding their contract. The penalties can be high depending on the penalty clause and how quickly the loan is refinanced or the house is re-sold.

While some dated research suggests that loan prepayment penalties are beneficial to the borrower because they lead to better contract conditions, it won’t be beneficial if you don’t know how to best handle the prepayment penalties on your loan.

Share on facebook
Share on twitter
Share on linkedin
Share on email

Start your loan application

Lender / Broker? Request a demo